As a business owner, if you are considering expanding your company, be sure to get your financial statements in order before asking for a business loan. When evaluating a company’s request for a loan, banks will use a series of financial ratios and metrics to determine how the business is doing in an attempt to estimate its risk of default. Financial statements provide critical information and allow the banks to calculate the metrics that are important to them. When one of these key calculations is outside the norm, a red flag goes up on their end — and the loan may be denied.
Common metrics
To avoid getting denied in this manner, business owners should familiarize themselves with some of the more common metrics that banks use to measure creditworthiness.
For example, banks will compare cash and receivables to current liabilities. If this ratio starts slipping, you’ll likely need to push accounts receivable so money comes in more quickly or better manage inventory to keep cash flow moving. Other examples of financial benchmarks include:
- Gross margin
- Current ratio (current assets / current liabilities),
- Total asset turnover ratio (annual revenue / total assets), and
- Interest coverage ratio (earnings before interest and taxes / interest expense).
Some banks may also utilize company- or industry-specific performance metrics. For instance, a warehouse might report daily shipments or inventory turnover, not just total asset turnover. Meanwhile, a retailer might provide sales graphs that highlight product mix, sales rep performance, daily units sold and variances over the same week’s sales from the previous year.
Other methods
Bear in mind that not every bank uses the same metrics to evaluate performance, or they may combine ratio analysis with other benchmarking tools. Some use community-based scoring, by which a selected group of finance professionals rate and review companies based on their payment histories. Others use proprietary commercial-scoring models that use creditor reports to develop credit scores for businesses.
Preventing disappointment
When your strategic initiative fails to launch because the business can’t obtain financing, it can be crushing. To prevent such disappointment, be prepared, have your financial statements in order and target as many common ratios as possible. Contact us for help evaluating your performance and determining where you may need to improve your metrics in order to help obtain a loan.